Tuesday, March 01, 2005

Insurance: How Big a Problem Is Adverse Selection?

There is a general presumption in the economics of risk and insurance that people who are especially high risk will be the ones who will benefit most from buying broad-category insurance, and the low-risk people will end up subsidizing them. This is the problem of "adverse selection." Wikipedia has an excellent presentation of the basics.

Economists miss one of the biggest problems with insurance. We are blinkered by adverse selection models, which imply that the dangerous prospects most want to buy insurance. The opposite is more often true. If you are an irresponsible driver, you are likely to be irresponsible in other spheres as well and not buy auto insurance. On the whole many insurance markets show positive rather than adverse selection. In a development context, this means that the people who most need insurance will be the least likely to buy it.

I expect this criticism of adverse selection applies in many other areas as well; otherwise there would not be so many jurisdictions that require all drivers to carry liability insurance, and in general our in loco parentis policies [aka "the nanny economy"] can sometimes be justified if people who are irresponsible are so irresponsible as to not seek out information about the risks and expected costs of their actions.

It is difficult to propose efficient rules about negligence that have the desired incentive effects for these people.

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